Why interest rates matter

Some context: I find that almost no one understands what interest rates are and what the Federal Reserve did last week when it “left rates unchanged.” But interest rates are important. Below is my brief, basic explanation of what interest rates are, what the Federal Reserve is doing when they set interest rates, and why timing interest rate hikes is a delicate task.


Interest is a price.

This isn’t a figure of speech. Interest is the literal price of borrowing money. It’s what we pay, in terms of future money, for the privilege of using someone else’s money in the present.

All prices, in turn, are informative. In fact, this is their essence: prices are a mechanism for communicating information about the world—specifically about how supply and demand conditions change. Friedrich Hayek explains:

We must look at the price system as such a mechanism for communicating information if we want to understand its real function … In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. It is more than metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.

This information isn’t just incidental. It doesn’t just help “those concerned” find opportunities that otherwise would have simply gone unrealized. It’s vital to the successful functioning of business everywhere. It facilitates rational economic calculation and makes sustained profit possible.

Interest is a price, prices are information, and information is essential to the rational economic order. Clearly, the implications here are many. One in particular is of unique importance this year, as the Federal Reserve begins to tinker with interest rates after more than 80 months of near-zero rates following the financial crisis.

Now, I’ve been skeptical of talk that the Fed was ever serious about raising interest rates this year. I predicted in December 2014 that we’d see no rate hike in 2015, and I was almost correct (missed it by a month). But whether I was right or wrong doesn’t change how interest rate hikes (and cuts) affect economic activity. Whether the Fed does or does not raise rates doesn’t dampen the unprecedented risk the Fed takes by artificially manipulating interest rates in pursuit of even the noblest of goals.

We’ll start with premise #1: That the Fed manipulates interest in order to effect change in the economy. This is undisputed. Monetary policy actions (like manipulating interest rates) is the central bank’s tool to combat recession, and the only sphere over which it maintains an almost absolute controlling power. By lowering interest rates following the 2008 recession, the Fed sought to boost the availability of credit (that is, make borrowing money easier by lowering the price of borrowing money) in an otherwise recessionary environment which would likely have seen rates skyrocket. This would put downward pressure on things like business creation and investment, home and car ownership, etc.

Premise #2 is related: Interest rate manipulation has real effects on economic activity. If this weren’t the case, why would the Fed fix rates? By lowering interest rates, the Fed did stimulate lending and business activity that otherwise would not have happened. It staved off further liquidation by purchasing bad assets from banks, and infused confidence into markets that likely propped up things like household spending and borrowing, employment, and investment.

Conclusion: Mistiming an interest rate hike could have seriously traumatic implications for global economic health. If the Fed raises rates too soon (that is, before the “natural” rate has risen equivalently), it risks destabilizing an unrealized equilibrium and undoing what steps entrepreneurs have taken thus far to re-establish their economic footing. If it raises rates too late, it risks inflating a speculative bubble–the type that burst in 2008, after a quick rate hike followed by several years of low rates.

Now, whether it’s possible for the Fed to accurately time an interest rate hike is, itself, a worthwhile question…

Dehomogenizing deflation

From Selgin, Lastrapes, and White:

The postwar eradication of deflation would count among the Fed’s achievements were deflation always a bad thing. But is it? Many economists appear to assume so. But a contrasting view, supported by a number of recent studies, holds that deflation may be either harmful or benign depending on its underlying cause. Harmful deflation—the sort that goes hand-in-hand with depression—results from a contraction in overall spending or aggregate demand for goods in a world of sticky prices. As people try to rebuild their money balances they spend less of their income on goods. Slack demand gives rise to unsold inventories, discouraging production as it depresses equilibrium prices. Benign deflation, by contrast, is driven by improvements in aggregate supply—that is, by general reductions in unit production costs—which allow more goods to be produced from any given quantity of factors and which are therefore much more likely to be quickly and fully reflected in corresponding adjustments to actual (and not just equilibrium) prices.

Historically, benign deflation has been the far more common type.

In other words, not all falls in the price level are bad. When prices fall because of improvements in productive technologies, for example, that’s good. That’s the point of growth. That is growth.

Brief musings on the market

  1. The DJIA lost 3.57 percent today. Last Friday it lost 3.12 percent. This is nowhere near even the 20th worst day in the DJIA’s history—a 6.98 percent loss on September 29, 2008. But the past two trading days do represent the DJIA’s 19th and 20th worst daily point losses ever.
  2. Most economists think Greenspan’s Fed left interest rates too low for too long when rates hovered between one and two percent for 32 months between December 2001 and May 2004. But that’s nothing compared to today, which marks roughly 80 months of near-zero rates.
  3. Even if the U.S. stock market recovers somewhat in the next few weeks, problems in China have proven to be very fundamental and very serious. I take this as another good reason to believe my 8-month old prediction—that the Fed will not raise rates in 2015. China is in full-on stimulus mode, and sharp divergence between central banks’ policies makes conducting monetary policy in the U.S. difficult. If the Fed continues to flirt with the idea of a rate hike, it will be while China, Japan, and the Eurozone still meddle with stimulus. At the very least, this risks boosting the dollar’s value even further and weakening U.S. exports in the process. Larry Summers made this point in the Financial Times today. I explained it last fall.

Dark clouds looming

A good piece from The Economist on “the dark clouds around the silver lining” of Fed monetary policy. A highlight:

…constraining the economy to so low a rate of average inflation is a good way to ensure that very low inflation or deflation becomes a serious threat whenever the next shock hits. That would be nasty in and of itself, given what we have learned about wage rigidity over the course of this business cycle. It is made all the worse by the very high probability that interest rates will quickly fall back to zero during the next downturn. That’s the third reason to pull one’s hair out over the Fed’s preferred approach: the lower the average inflation rate, the lower the nominal interest rate consistent with normal economic growth, and the higher the odds of hitting the zero lower bound whenever trouble strikes.

And the kicker:

…the Fed is the world’s monetary pacesetter, and it is rapidly moving toward tightening at a time when a disinflationary freeze is settling in around the rest of the globe. The Fed may tell itself that its responsibility is to take a very narrow, domestic view. Given the interconnectedness of the global financial system, taking a narrow, domestic view strikes me as a bad idea, even in terms of pure American self-interest.

I think this author is on to something important, but I don’t agree that the Fed is going to be as hawkish as he thinks. I don’t expect a rate hike in 2015 largely for those reasons this author cites. In short, I don’t think the Fed is “rapidly moving toward tightening” right now.

The Fed is frustrating (and won’t raise rates in 2015)

The Editors at BloombergView are spot on with this one:

Here’s the point, and it’s really quite simple: The Fed doesn’t know when it will start to raise interest rates, nor should it have to know, nor should it indulge analysts’ misconceived determination to find out. Interest-rate changes are not, and should not be, on a schedule. They depend entirely on what happens in the economy, and the Fed — like every last one of those analysts — doesn’t know what will happen. What it can and should do is draw attention to the economic indicators it is following — in particular, indications of inflation pressure in the labor market. The rest just sows confusion.

On a related note, I made a public prediction earlier this week that the Fed will not raise rates in 2015. Inflation, as measured by the Fed’s preferred PCEPI, is just too low. Fears of runaway inflation are totally unfounded in the data. Yes, stock values are soaring high enough to scare some investors, but Yellen has insisted that the presence of speculative bubbles is no reason to raise rates. That decision will come, she says, only once the two arms of the Fed’s dual mandate—unemployment and inflation—look good. And right now, inflation looks anything but. Yellen has always been a deflation hawk, anyways.

For more of my views on this topic, see my recent piece at Enhancing Capital. This is the startup I’ve mentioned on my blog before—an investments e-newsletter that “brings market analysis to life.” In this case, that’s more than just a cheesy slogan. They do some pretty cool stuff with data visualization that keeps things simple and straightforward without sacrificing depth of research. Most of my content there regards larger economic trends, but stock picks and sector analyses are their specialty. Check ’em out!

Central banking like it’s 1989

Ashley Kindergan writes a great piece at The Financialist on the growing divergence between central banks, the likes of which we haven’t seen in 25 years.

In 2015, global monetary policy could look like a mirror image of its 1989 self. The Bank of Japan already expanded the scope of its asset purchases in October. The European Central Bank is expected to announce quantitative easing as early as the first quarter, while the U.S. and the U.K. are expected to start tightening monetary policy in mid-2015. That’s because policy makers’ concerns have been reversed as well, with deflation a bigger worry than inflation in Europe and Japan (a 40 percent drop in crude oil prices since June has exacerbated the deflationary dynamic), and inflation emerging as a potential concern of the Fed and the Bank of England.

One qualm: I’m a little skeptical that inflation fears will be the prime mover behind Fed policymaking in 2015. The economy may be looking up as equity values soar and unemployment continues to decline, but inflation itself remains low. Janet Yellen is a deflation hawk, anyway, having repeatedly dismissed inflation fears in the past. The collapse of oil prices adds deflationary pressures to the mix that, I think, will dissuade Fed officials from raising rates in 2015. Near-zero rates through 2016 is what Janet Yellen originally wanted, anyways.

But either way, how the world’s central banks respond to these contrasting inflationary and deflationary pressures will certainly be one of the coming months’ big stories. Here’s Barry Ritholtz saying as much at Bloomberg today:

The central bankers of the world are out of synch with each other. If the U.S. economy continues to accelerate, this disparity may become even more pronounced. How that plays out could be the big question facing central bankers in 2015.

The Fed especially has an interesting puzzle, as unemployment drops ever lower while inflation remains low—a situation The Economist calls “contradictory pressures” in it’s print edition this month. A working assumption behind the economics of the Fed’s dual mandate is that inflation and unemployment should move somewhat in tandem, and that the decision to ease off the monetary gas pedal should come when both indicators look good. But what happens when one indicator moves opposite the other—when inflation drops as job growth rises, as we’re seeing today? Can unemployment get “too low” as the Fed waits for inflation to pick up before raising interest rates? Will a rate hike spark deflationary fears if the Fed acts in response to strong jobs reports while inflation remains low?

(On that note, remember when 6.5 percent unemployment was supposed to trigger a rate hike? In retrospect, that was probably one of Ben Bernanke’s worst ideas. Pegging the end of easy money to a specific unemployment rate might have eased fears of a rate hike when unemployment was still well above 6.5 percent, but pegging the two events together like that created a perverse incentive—one I wrote about last year—that turned low unemployment into something stimulus-addicted markets didn’t like.)

There is no real trade-off between loans and reserves

In this piece at Reason.com, economist Robert Murphy writes the following:

But the U.S. economy has stayed in this holding pattern, where people expect low consumer price inflation and so commercial banks keep their excess reserves earning 25 basis points parked at the Fed rather than make new loans. Thus the process I described above has been thwarted; the quantity of money held by the public right now is much lower than it would be, if the banks decided they would rather make loans and earn a higher interest rate than the 25 basis points currently paid by the Fed.

Unfortunately, this statement implies something about how banking works that is simply untrue, which leads Murphy to some incorrect conclusions about QE’s effect on the economy and what to think about inflation. I don’t like seeing this because I like Murphy and the school of economics he espouses. I also see this same mistake made quite often by other economists, which only confuses everyone. So here’s my attempt at explaining this error in a constructive and uncritical manner:

There is no trade-off between loans and reserves except to the extent that new loans results in higher demand for banknotes.

This is seen by the fact of how the central bank’s balance sheet looks:

ΔAssets (A) = ΔReserves (R) + ΔBanknotes in circulation (BK) + ΔGovernment deposits (GD)

Rearranged, this equation looks like:

ΔR = ΔA – ΔBK – ΔGD

The implication here is that levels of reserves can change in only three ways:

  1. The central bank increases or decreases its assets (Fed action).
  2. The public increases or decreases the amount of banknotes (cash) it wants to hold (public’s actions).
  3. The government increases or decreases its deposits by making or receiving net transfers to or from the private sector (government action).

Now, Murphy’s point regards the actions of commercial banks. He says that are choosing to keep their reserves “parked” at the Fed rather than make new loans.

But as I explained above, banks cannot change the amount of reserves in the system apart from actions by the Fed, the public or the government. They cannot, by making new loans, shed reserves or somehow turn reserves into an investment that earns a higher interest rate.

But one might ask: Doesn’t a new loan involve turning reserves (low-interest into loaned funds (higher-interest)?

The answer is no. When banks make a loan, they simply credit the borrowers account at the Fed (corrected 12/28/14) with new funds. They don’t take this from their reserves. They are, however, limited in the amount of funds they can loan by mandated reserve-requirement ratios. Every new loan moves them close to becoming reserve-constrained. But when they make a loan, they move closer to this limit by increasing the size of their balance sheet all around—not by moving funds around. Their total level of reserves stays the same and the total level of loaned funds increases.

In short, a new loan’s effect on a bank, ceteris paribus, is to increase assets by the amount of the loan. A loan has no effect on reserves.

Now, what could affect reserves is how borrowers use those loaned funds (public’s actions). If the loan causes demand for banknotes (cash) to increase, then reserves will fall as banks redeem such demands with banknotes. Outflow of banknotes, as explained above, reduces reserves for the bank in question, as well as for the system as a whole (assuming those banknotes aren’t withdrawn and then deposited in another bank, which merely transfers reserves from one bank to another).

Another way reserves could fall is if the borrower writes a check against their loaned funds account to someone who uses a different bank. This would result in a transfer of reserves out of the borrower’s bank and into the bank of the person to whom the check was written. This wouldn’t result in net loss of reserves for the system as a whole, though. It just transfers reserves from one bank to another.

So when Murphy says that banks might decide to make loans “rather” than keep reserves parked at the Fed, he’s mistaken. Banks might decide to increase lending, but not at the expense of losing interest on reserves at the Fed. In fact, banks would rather earn interest on both new loans and reserves at the Fed (which is possible because new loans don’t require an outflow of reserves). Ideally, Bob would write a check against his loaned funds account that is addressed to another customer of that bank. Then the bank sees no loss in reserves (and so earns the same interest on the reserves as before) plus an increase in loaned funds which, of course, earns interest.

This is a very subtle point, but has huge implications for predicting inflation and gauging the effects of QE and growth in the monetary base. For example, there is no threat of sky-high levels of reserves “turning into” loans funds and thereby launching us into hyperinflation. Sure, a higher level of reserves pushes banks further from being constrained by their reserve-requirement ratio, which means they can increase lending. But banks are normally not reserve-constrained, so the relationship between reserves and loans is not direct, and might be hardly related at all.

This is not to say that inflation won’t happen at all, or that QE doesn’t fund malinvestment to levels that will ultimately prove unsustainable. In fact, Murphy is right about the general, distortive effects of QE. He’s just wrong about why QE induces more lending, which has implications for his predictions regarding inflation (and, I think, might explain why his original predictions were wrong).

Now, if you’re following this closely, you might have a question: If reserves can’t be lent out and don’t have a substantial effect on how much banks lend, what’s the point of increasing them with QE?

The answer is that QE changes the aggregate portfolio composition held by the private sector by buying government debt and other securities with reserves and bank deposits—something economist Paul Sheard aptly calls “portfolio rebalancing effects.” In short, this induces more confidence among borrowers and encourages banks to lend by “liquefying” their balance sheets.

In short, banks cannot lend out reserves. We shouldn’t expect to see any net outflow of reserves apart from action on the part of the Fed and the government unless the public increases it’s demand to hold cash—an event over which individual banks have virtually no control.

So Murphy is wrong to say that banks might choose to lend “rather than” keep reserves parked at the Fed. When they lend, their reserves stay parked at the Fed no matter what.

And finally, note the implication here that banks wouldn’t want to see diminished reserves as long as interest paid on those reserves is positive. Even if interest rates on loans and other investments is higher, they’d rather earn interest both on their reserves at the Fed plus on these higher-earning investments. This is possible, again, because loans do not “come from” excess reserves. As Sheard explains:

…banks do not need excess reserves to be able to lend. They need willing borrowers and enough capital – the central bank will always supply the necessary amount of reserves, given its monetary stance (policy rate and reserve requirements).

For further reading, check out this short, excellent paper by Paul Sheard (here’s a one-page summary if you really don’t have time). I’m channeling him, really, as well as Forbes’ Frances Coppola and Nathan Lewis.

Finally, while I think I understand this issue quite well, I’m no expert on banking. Let me know if I’ve made a mistake and I’ll make updates as appropriate.

Here’s nice summary of four economists’ in-their-own-words views on why inflation is so low despite five years of quantitative easing. I find Schiff unconvincing, Henderson refreshing, Sumner quite convincing, and Murphy wrong (disappointingly). Check it out and see if you can tell why.

The Fed to investigate itself for regulatory capture

I’ve written before about regulatory capture at the Fed. Now even the Fed has been forced to respond, but they still don’t seem to take all this seriously. According to Fortune,

William Dudley, who heads the New York Fed and is consequently responsible for supervising most of the country’s largest banks, will tell a Senate committee later today that a new review into its supervisory practises will look specifically at the issue of ‘regulatory capture’–the idea that a supervisor tasked with upholding the public interest ends up under the influence of the companies it is supposed to be monitoring.

This report implies that the Fed will investigate itself for regulatory capture. Doesn’t that ruin the point? What about regulatory capture of this review? Will the Fed later investigate this investigative process for signs of corruption?

If they were serious about removing the influence of regulatory capture from their decision-making processes, they’d bring in outsiders–qualified critics of the Fed who’ve been investigating this for years. Experts who know what regulatory capture looks like. Investigators who aren’t on the Fed’s payroll.

For the cherry on top, note that most allegations of regulatory capture in the past regard Goldman Sachs—Dudley’s old employer. I assume he’ll be investigating himself, too?

Here’s Dudley himself responding to the Fed’s critics.

I don’t think anyone should question our motives or what we are attempting to accomplish.

This says lots about the Fed supervisors’ mindsets, I think, and explains the habitual lack of seriousness with which they’ve takes these allegations. Call it a power trip, groupthink, a delusion of granduer…whatever it is, it’s not right.

For more reading on this investigation, I suggest this Financial Times report.

Corruption at the Fed

Senators Elizabeth Warren and Sherrod Brown have called for an investigation of the Federal Reserve Bank of New York. This comes as a response to a ProPublica article by Jake Bernstein, true yeoman’s work, that exposes an all-too-cozy relationship between the Fed and Goldman Sachs. Relying on secret recordings made by a former Fed compliance attorney, he writes:

In a tense, 40-minute meeting recorded the week before she was fired, Segarra’s boss repeatedly tries to persuade her to change her conclusion that Goldman was missing a policy to handle conflicts of interest. Segarra offered to review her evidence with higher-ups and told her boss she would accept being overruled once her findings were submitted. It wasn’t enough.

“Why do you have to say there’s no policy?” her boss said near the end of the grueling session.

“Professionally,” Segarra responded, “I cannot agree.”

The New York Fed disputes Segarra’s claim that she was fired in retaliation.

As far as I can tell, this story boils down to the firing of Carmen Segarra, an “expert examiner” hired by the Fed who dared to ask questions of her Fed boss about Goldman Sachs’ nonexistent conflict of interest policy. The concern here is that Goldman Sachs has undue influence over policy making at the New York Fed–more specifically, that Fed officials aren’t willing to hold Goldman Sachs accountable.

A classic case of regulatory capture, if you ask me. And why aren’t Republicans on top of issues like this? Where’s Rand Paul? I like most Republicans, but their apparent unwillingness to involve themselves in issues like this–issues other than run-of-the-mill low taxes, less regulation, more freedom, etc.–will doom them among young voters, if it hasn’t already.

Update: Apparently Michael Lewis has covered this story for Bloomberg. He highlights the following quote that should get people’s attention:

for instance, in one meeting a Goldman employee expressed the view that “once clients are wealthy enough certain consumer laws don’t apply to them.” After that meeting, Segarra turned to a fellow Fed regulator and said how surprised she was by that statement — to which the regulator replied, “You didn’t hear that.”